1.3 Market Failure

Cost or benefit a third party receives from an economic transaction outside of the market mechanism.

Costs / benefits to the individual participating in the economic activity

Costs / benefits of the activity to society as a whole

Costs / benefits to a third party not involved in the economic activity. They are the difference between private costs / benefits and social costs / benefits.

A good with external benefits, where the benefit to society is greater than the benefit to the individual.

Tend to be underprovided in a free market

A good with external costs, where the cost to society is greater than the cost to the individual.

They tend to be over-provided by the free market.

Public goods are non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free-rider problem.

Goods which aren’t perfectly non rivalry and non excludable but aren’t perfectly rival and excludable e.g. roads as some have tolls and traffic.

You cannot charge an individual a price for the provision of a non-excludable good because someone else will gain the benefit from it without paying anything.

Private sector producers will not provide public goods to people because they cannot be sure of making a profit.

Consumers and producers don’t have perfect information and hence don’t know the full costs and benefits of a decision. Hence, they don’t always act rationally.

Misallocation of resources because people do not buy things that maximise their welfare.

Buyers and sellers have potential access to the same information; this is perfect information.

One party has superior knowledge compared to another. Usually, the seller has more information than the buyer and this means they can take advantage of the other party’s lack of knowledge, by charging them a higher price.